Behavioral Finance and Wealth Management

I have just finished reading a book named “Behavioral Finance and Wealth Management” by Michael M. Pompian, CFA, CFP

The author, who obtained both of the 2 renowned credentials and has spent a long time in the profession, shared his perspective about how behavioral finance can help better service the clients in portfolio management. 

He started the book by providing essential information about behavioral finance (its history, development, key people, etc.).

I think one of the most important points the author made is to distinguish between standard finance and behavioral finance. He quoted Meir Statman’s “People in standard finance are rational. People in behavioral finance are normal.”  

• ·      Behavioral finance studies the effects of human emotions and cognitive errors on financial decisions, i.e. the application of psychology to finance. On the other hand, standard finance theory is designed to provide mathematically elegant explanations for financial questions and relies on a set of assumptions that oversimplify reality. The key notion of standard finance is “Homo Economicus” (rational economic man) which prescribes that humans make perfectly rational economic decisions at all times. The reasons for using such concept are to make economic analysis relatively simple and to quantify the economic findings. The threes underlying assumptions for this Homo Economicus, namely Perfect Rationality, Perfect Self-Interest and Perfect Information, are heavily criticized.
• ·    Standard finance is built on rules about how investors “should” behave, rather than on principles describing how they actually behave. Behavioral finance attempts to identify and learn from the human psychological phenomena at work in financial markets and within individual investors.
• ·        Standard finance grounds its assumptions in idealized financial behavior; behavioral finance grounds its assumptions in observed financial behavior.

It should be reminded again that there is a big gap between standard and behavioral finance, between theory and real life.

Behavioral finance is classified into 2 groups:

• ·        Behavioral Finance Micro: examines behaviors or biases of individual investors that distinguish them from the rational actors envisioned in classical economic theory. The key question would be: “Are individual investors perfectly rational, or can cognitive and emotional errors impact their financial decisions?”
• ·        Behavioral Finance Macro: detects and describes anomalies in the efficient market hypothesis that behavioral models may explain. The key question would be “Are markets efficient or are they subject to behavioral effects?”

Among the 2 groups, Finance Micro surely has more applications in wealth management profession. That’s also the focus of the book – how cognitive and emotional errors can impact investors’ financial decisions and how financial advisors should react to help the customers to overcome those errors. The author proposed a framework to treat the errors differently based on type of errors (cognitive or emotional) and based on customers’ financial situations.

Financial advisors should constantly remind themselves that: Investor-Advisor relationship is similar to other kinds of relationship. Investment results are not the primary reason that a client seeks a new advisor. The number-one reason that practitioners lose clients is that clients do not feel as though their advisors understand, or attempt to understand, the clients’ financial objectives. By getting inside the head of the client and developing a comprehensive grasp of her motives and fears, the advisor can help the client to better understand why a portfolio is designed the way it is and why it is the “right” portfolio for her – regardless of what happens from day to day in the markets.

The author then cited the guidance of Kahneman and Riepe for financial advisor: “To advise effectively, advisors must be guided by an accurate picture of the cognitive and emotional weaknesses of investors that relate to making investment decisions: their occasionally faulty assessment of their own interests and true wishes, the relevant facts that they tend to ignore, and the limits of their ability to accept advice and to live with the decisions they make.”

The book then seeks to help financial advisors to deal with 20 most common investor biases. With each bias, the author provides the readers with definition, description, classification, practical application, research review, diagnostic tests and advice. So it would be very convenient for the advisor to look up for the bias that they find with their customers and deal with them effectively.

Overconfidence: people think they are smarter and have better information than they actually do. Wealth hazards:

-          Unfounded belief in own ability to identify companies as potential investments

-          Excessive trading

-          Underestimating downside risks

-          Portfolio under-diversification

1.  Representative: people categorize and classify to wrongly simulate the situation based on their experiences. Two primary interpretations are Base-rate Neglect (relying on stereotypes) and Sample-size Neglect (the sample is not representative of the population).
2. Anchoring and adjustment: When required to estimate a value with unknown magnitude, people generally begin by envisioning some initial, default number – an anchor – which they then adjust up or down to reflect subsequent information and analysis. Regardless of how initial anchors were chosen, people tend to adjust their anchors insufficiently and produce biased end approximations.
3. Understanding anchoring and adjustment can be powerful asset when negotiating. When negotiating, it is wise to start with an offer much less generous than reflects your actual position. Conversely, if a rival negotiator makes a first bid, do not assume that this number closely approximates a potential final price.
4. Cognitive dissonance: the mental discomfort when newly acquired information conflicts with preexisting understandings. People try to convince themselves that the new information is incorrect or stick to their false original decision.
5. Availability: a rule of thumb, or mental shortcut, that allows people to estimate the probability of an outcome based on how prevalent or familiar that outcome appears in their lives.
6. Self-attribution: the tendency of individuals to ascribe their successes to innate aspects, such as talent or foresight, while more often blaming failures on outside influences, such as bad luck.
7. Illusion of control: describes the tendency of human beings to believe that they can control or influence outcomes when, in fact, they cannot.
8. Conservatism: a mental process in which people cling to their prior views or forecasts at the expense of acknowledging new information.
9. Ambiguity aversion: people do not like to gamble when probability of distributions seem uncertain. People who are ambiguity averse may not be investing in certain equity asset classes because they demand too high an equity premium. Financial education is the solution
10. Endowment: People value an asset more when they hold property rights to it than when they don’t. If out-of-pocket costs are viewed as losses and opportunity costs are viewed as foregone gains, the former will be more heavily weighted. Two common mistakes caused by endowment bias: investors may hold onto securities that they already own (1) in order to avoid the transaction costs associated with unloading those securities (2) because of familiarity. (3) Because that they inherited them.
11. Self-control bias: a human behavioral tendency that causes people to consume today at the expense of saving for tomorrow and thus fail to plan for retirement or make asset-allocation imbalance.
12. Optimism
13. Mental accounting: People’s tendencies to code, categorize, and evaluate economic outcomes b grouping their assets into any number of nonfungible (noninterchangeable) mental accounts.
14. Confirmation: refers to a type of selective perception that emphasizes ideas that confirm our beliefs, while devaluing whatever contradicts our beliefs

“It is the peculiar and perpetual error of the human understanding to be more moved and excited by affirmatives than by negatives.” – Francis Bacon

   

   15.  Hindsight: The tendency to perceive that the event was predictable – even if it wasn’t.

   16.  Loss aversion: Psychologically, the possibility of a loss is on average twice as powerful a motivator as the possibility of making a gain of equal magnitude. Loss aversion can prevent people from unloading unprofitable investments, even when they see little to no prospect of a turnaround. It can also causes investors to sell winning positions too early, fearing that their profits will evaporate otherwise (this behavior limits the upside potential of a portfolio and can lead to overtrading) => This is a bias that I often commit as I am too risk averse and timid to take on challenge.

“Win as if you were used to it, lose as if you enjoyed it for a change.” – Ralph Waldo Emerson

   17.  Recency: A cognitive predisposition that causes people to more prominently recall and emphasize recent events and observations tan those that occurred in the near o distant past.

“The past and present are our means; the future alone is our goal.” – Blaise Pascal (1623-1662)

   18.  Regret aversion: The fear that whatever course they select will prove less than optimal. This bias seeks to forestall the pain of regret associated with poor decision making, causing investors to hold onto losing positions too long in order to avoid admitting errors and realizing losses. This bias would lead to investing too conservatively, staying out of the market after a loss, holding losing/winning positions too long, herding behavior and limited preference for famous companies

   19.  Framing: the tendency of decision makers to respond to various situations differently based on the context in which a choice is presented. This should be paid a lot of attention as thing presented will be viewed differently depending whether it is framed positively or negatively.

“You better cut the pizza in four pieces, because I’m not hungry enough to eat six” – Yogi Berra.

  20.  Status quo: An emotional bias that predispose people facing an array of choice options to elect whatever option ratifies or extends the existing condition in lieu of alternative options that might bring about change.

“Whoever desires constant success must change his conduct with the times” – Niccolo Machiavelli

I think this book will be very useful for financial advisor to understand their clients’ problems/issues and better communicate with them. The author also discussed some case studies as well as some special topics in behavioral finance. The case studies would be interesting in behavioral finance courses and the special topics would be food for thought for those who are curious about what would be the next steps in the field.